January 2008

Cityphilia
At the point when we bought our house in 1996, average house prices in the UK, adjusted for inflation, were some way below the levels theyd hit in the late 1980s bubble. Clapham was then still a place people moved to when they had families and wanted larger and cheaper houses, and were willing to move south of the river to get them. When house prices began to go up, this area began to be colonised by bankers and City types. We were the last non-City people to move into the street where we live the last of the aborigines. These days, as houses become an ever more critical capital asset, there is a constant va-et-vient of renovation, a non-stop turmoil of attics being done, basements being dug out, skips being filled, scaffolding put up and everything knockable being knocked through. In a street two hundred metres long, there is at the moment one skip, three sets of scaffolding, two basement conversions, a loft conversion and two full renovations. Most of this activity is generated by the City people, since we aborigines for the most part tend not to move; were all still here. But the bankers move all the time, doing up and selling on houses, usually to move to the Old Rectory in Shaghampton, Wiltshire, with the husband spending three or more nights in town until the inevitable happens. (Half of my business is The Old Rectory, Wiltshire, a cheerful divorce lawyer once told me.) Ive nothing against bankers; my father was one. But it isnt possible to deny that in most of London, City money has a negative impact on the quality of life. Its partly that the men, in particular, can be so insanely boring. That may reflect the way banking has changed, become more intense, more time-consuming and more overtly greedy. David Kynaston, author of a magisterial four-volume history of the City, completed in 2001, observes at the start of the fourth volume that the modern City is in many ways a cruel, heartless place, and its occupants work such cripplingly long hours that inevitably they lack much of the roundedness of earlier generations. From a parochial point of view, the City types effect on the texture of life is not heartwarming. The bankers dont use the local schools or hospitals or shops: at least not until the shops catch up with them, and then when the shops do catch up with them they are selling things at such high prices that no one else can afford them. During the week, the men are functionally invisible: they leave the house around 6.30 and are back at about eight. At the weekends, when you see them with the children, they go to heroic lengths as Jonathan Coe points out in The Closed Circle to occupy themselves doing exactly the same things they would be doing if the children werent there: reading papers, sending emails, talking on the phone. When the children are small the wives occupy themselves in the supervision of nannies and builders: once the children are in school full-time they go back to work; when the time for secondary education comes, they move to the country, and another set of bankers moves in. Not all City types are vile, obviously. My friend Tony isnt vile. We have many interests in common and chat easily about all sorts of things. But Im sometimes made aware of a significant gap between us. Its a philosophical and practical gap, and it is to do with money. Tony will complain

about the price of things about parking permits, or the cost of the Playstation 3 hes promised his son but Ive begun to wonder if this is a purely formal acknowledgment of the value of money to other people. Tonys basic is 120,000 a year; in a good year he earns a bonus of 500,000. In a very good year he is paid a million pounds. He is polite about this but the details slip out nonetheless. He bought a second home on Ibiza and I was commiserating with his complaints about the usual things (builders, local regulations) until the cost of the house was mentioned: 1.4 million. A fundamental economic gap of that type does open up a distance between people, however many other things you have in common. He happened once to mention what he (as a head of department) pays new recruits, straight out of university: 45k a year, with a bonus of between ten and twelve grand guaranteed. I pointed out that in many cases that would mean these 22-yearolds would be earning more than the heads of department in the universities theyd just graduated from. He shrugged and laughed. It is what it is, he said. Also, the bottom-performing 10 per cent of people in every department at his firm are sacked every year. He expressed surprise at my surprise. Thats standard, he said. I thought everyone did that. The moments when I realise Tony and I occupy very different spaces always turn on money and the assumptions built into our attitudes to it. In London, as a rule, non-City people dont love City people, and there isnt much non-economic interaction between them. The bonuses are a big part of that. The City is, collectively, astonishingly wealthy. It earns 19 per cent of Britains GDP. People dont mind that in itself but they do mind City bonuses. Last year, these amounted to a truly boggling 19 billion, all of it paid at the end of the year. In London, the effect of that money has become almost entirely toxic. Im not talking here about middle-class envy the resentment increasingly expressed among the middle-class poor about how unfair it is that these bankers get paid so much for contributing so little. That resentment seems to me to be largely hypocritical, a middle-class resentment of one of the few forms of inequality that doesnt benefit them. But City money is strangling London life. The presence of so many people who dont have to care what things cost raises the price of everything, and in the area of housing, in particular, is causing Londons demographics to look like the radiation map of a thermonuclear blast. In this analogy only the City types can survive close to the heart of the explosion. At this time of year, when the bonus stories come out, you can understand why. A bar announces that it is offering the most expensive cocktail in the world: 35,000. That buys you a shot of cognac, a half bottle of champagne, a diamond ring and the attentions of two security guards to protect you for the rest of the evening. A deli, at the special request of a customer, creates a 50,000 Christmas hamper. Word gets out, and another customer immediately orders two more. The expense of London is forcing people further and further out of the city, and making life harder and harder for the ones who remain. There is no mystery about how we got to this point: successive governments have, in policy terms, given the City more or less everything it wants. One of the last big things any government did to piss the City off truly piss it off was the windfall tax on profits imposed in 1981 by Mrs

Thatchers chancellor Geoffrey Howe. (Blair or Brown would never dream of doing anything like that to the City.) But the abolition of exchange controls in 1979 and the increasingly international flow of capital, combined with the abolition of restrictions on trading practices which culminated in the Big Bang in 1986, have all led to the Citys increasing dominance of British economic life. This, in turn, makes it all the more striking how little knowledge most people have of what goes on in the City: what it is for, what it does, and how it affects everyday life for everybody else. This can come as a shock to even the best-informed citizens. James Carville, the Svengali behind Clintons election win in 1992, was so amazed by the power of freely moving capital, viewed at close range, he said that if reincarnation were real, he would like to be born again as the international bond markets. But the ordinary elector knows almost nothing about how these markets work and the impact they have. Kynaston observes that under Communism children from primary school upwards were taught the principles and practice of the system, and were thoroughly drilled in how it was supposed to work. There is nothing comparable to that in the capitalist world. The City is, in terms of its basic functioning, a far-off country of which we know little. What there is instead is, in Britain, a largely unthinking willingness for government to adopt City approaches to other aspects of society. Kynaston, discussing City cultural supremacy, says that in all sorts of ways (short-term performance, shareholder value, league tables) and in all sorts of areas (education, the NHS and the BBC, to name but three), bottom-line City imperatives had been transplanted wholesale into British society. This uncritical and uninformed governmental Cityphilia received its biggest shock in decades this autumn, with the near collapse of Britains fifth largest mortgage lender, Northern Rock. Britains first genuine bank run in more than a hundred years shone a light in many places where the sun doesnt routinely shine, and one of the first things to be brought into question was the ways banks work. As Ive already said, my father was a banker, and I grew up hearing about that mythical beast, the bank run. It was often spoken of but rarely seen in the wild. Bankers are said to dread a bank run, but my dad talked about them with a certain black humour. They were always a sign that somebody had fucked up, big-time. They can also be a sign that something in the financial system is fundamentally wrong. The question hanging around in the residue of the Rocks near implosion is which type of bank run this was a fuck-up, or a harbinger of meltdown? A well-run bank is a machine for making money. The basic principle of banking is to pay a low rate of interest to the people who lend money, and charge a higher rate of interest to the people who borrow money. The bank borrows at 3 per cent and lends at 6 per cent and as long as it keeps the two amounts in line, and makes sure that it lends money only to people who will be able to pay it back, it will reliably make money for ever. And this institution, in and of itself, will generate activity in the rest of the economy. The process is explained in Philip Coggans excellent primer on the City, The Money Machine (2002). Imagine, for the purpose of keeping things simple, a country with only one bank. A customer goes into the bank and deposits 200. Now the bank has 200 to invest, so it goes out and buys some shares with the money: not the full 200, but the amount minus the percentage which it deems prudent to keep in cash, just in case any depositors come and

make a withdrawal. That amount, called the cash ratio, is set by government: in this example lets say its 20 per cent. So our bank goes out and buys 160 of shares from, say, LRB Ltd. Then LRB goes and deposits its 160 in the bank; the bank now has 360 of deposits, of which it needs to keep only 20 per cent 72 in cash. So now it can go out and buy another 128 of shares in LRB, raising its total holding in LRB Ltd to 288. Once again, LRB Ltd goes and deposits the money in the bank, which goes out again and buys more shares, and so on the process goes. The only thing imposing a limit is the need to keep 20 per cent in cash, so the depositing-and-buying cycle ends when the bank has 200 in cash all the cash there is and 800 in LRB shares; it also has 1000 of customer deposits, the initial 200 plus all the money from the share transactions. The initial 200 has generated a balance sheet of 1000 in assets and 1000 in liabilities. Magic! In real life, its even better: the UK cash ratio is 0.15 per cent, so that initial 200 would generate 133,333 on both sides of the balance sheet. Now lets consider something a little more realistic: lots of different banks, with lots of different depositors and investments, many of them interlocking and overlapping. The specifics of who owns what, and who owes what, are almost unimaginably complex. Liquidity the ability to get hold of cash easily is crucial to this system, because your bank will often need money at shortish notice, to buy things or repay depositors. You know that if you lend money to another bank youll get it back without difficulty and they know the same about lending money to you. In normal circumstances, this isnt a problem: banks lend money to each other all the time, with complete ease and transparency, and this keeps the entire system afloat. But this depends on confidence; and it is this confidence that dried up for Northern Rock in the summer, when other banks became unwilling to lend it money, and it had to go to the Bank of England for the emergency loan which then triggered a bona fide bank run which is what happens when the people who own the 133,333 turn up demanding their money, and it turns out that the institution is in current possession only of its legally mandated 200 in cash. The reason banks became reluctant to lend money to each other was linked to risks arising from new types of financial instrument. Recent years have seen huge amounts of ingenuity applied to the devising of new types of investment vehicle. Most of these are forms of derivative, in which a product derives its value from something else. These are not new, nor is their involvement in financial disasters: it was tulip derivatives that underlay the Dutch crash of 1637. Derivatives have a bad press at the moment well be coming to that shortly but it is important to understand their role in the long history of mans attempt to understand, control and make money from risk. The best version of this story is told in Peter Bernsteins Against the Gods (1998), a fascinating account of risk, which makes the point that the study of risk is a humanist project, an attempt to abolish the idea of unknowable fate and replace it with the rational, quantifiable study of chance. The simplest forms of derivative are options and futures. An option gives you the right, but not the obligation, to buy or sell something at a specified future date for a specified price. Example: you spend 500 on an option to buy a Ferrari for 50,000 in a years time. When the year is up, the Ferrari is on sale for 60,000, so your option is now worth 10,000, because thats how much

money you can make by exercising the option, buying the car and then selling it for its real price. Conversely, if in a years time the Ferrari is on sale for 40,000, exercising your option would leave you out of pocket by 10,000 so you just let it go, and your only loss is the 500 premium (as its called). You could alternatively have bought the right to sell the Ferrari for 50,000 in which case your preferences would be reversed, and youd be hoping that the price had dropped. In that event youd buy the car for 40,000 and immediately sell it for 10,000 more. Futures are the same as options, except that they bring with them the obligation to buy or sell at the specified price: with futures, you are committed to the deal. It follows that futures are much riskier than options. Options and futures have been very important products in the history of finance, and it is no coincidence that derivatives were first extensively developed in commodities markets, especially the great exchange in Chicago (which started life 110 years ago as the Chicago Butter and Egg Board). A farmer facing an uncertain harvest is very grateful for the opportunity to sell his next seasons produce at a fixed price, guaranteed in advance. For years, derivatives existed as useful tools of this type: they were immensely practical but not in their basic essence too complicated. Their use was widespread, and Bernsteins account of them has some entertaining byways: who knew that the Confederacy funded its war against the Union with a derivative bond to attract foreign currency? But the trade in derivatives was hampered by one big thing: no one could work out how to price them. The interacting factors of time, risk, interest rates and price volatility were so complex that they defeated mathematicians until Fischer Black and Myron Scholes published a paper in 1973, one month after the Chicago Board Options Exchange had opened for business. Within months, traders were using equations and vocabulary straight out of Black-Scholes (as it is now universally known) and the worldwide derivatives business took off like a rocket. In an ideal world, one populated by vegetarians and Esperanto speakers, derivatives would be used for one thing only: reducing levels of risk. Because they are bought on margin i.e. not for the full cost of the underlying asset, but for the advance premium, as in the hypothetical Ferrari example above they offer a cheap and flexible form of insurance against things going wrong. Imagine that you are convinced that the stock market is about to go up by 50 per cent in the next year. You know it in your waters: so much so that you borrow 100,000 and use it to buy shares. If the market goes up youll be pleased with yourself, but if youre wrong, and the market plunges, youll be badly out of pocket unless you take out some insurance. So you buy a 10,000 option to sell the shares. That money is wasted if your shares go up but you wont care much because your main position is in serious profit. But if the shares lose half their value, you have some insurance: you can cash in the option to sell the shares and cancel out most of your losses. This is called hedging: you have used an option to hedge your main risk. Alas, we dont live in that kinder, gentler world. In reality, the power of derivatives has a way of proving irresistible to those people who arent just sure that the market is going up, but are beyond

sure, are super-sure, are possessed by absolute knowledge. In that event, it is very tempting indeed to buy an option that increases your level of risk, in the certainty that this will increase your level of reward. In the above example, instead of hedging the position with an option to sell, you could magnify it with options to buy more shares at the same price, which will be worth a lot if youre right sorry, when youre right. When youre right and the market goes up by half, your 10,000 option will be worth 50,000 (thats the 50,000 by which the shares have gone up). In fact, instead of buying 100,000 of shares and a 10,000 option to buy, why not instead buy 100,000 worth of options? This is called leverage: you have leveraged your 100,000 to buy 1,000,000 worth of exposure to the market. That way when you get your price rise, you have just made 500,000, and all with borrowed money. In fact, since youre not just confident but certain, why not skip the option and instead buy some futures, which are cheaper (because riskier) lets say half the price. These futures, at 5000 each, oblige you to buy 20 lots of the shares for 100,000 each in a years time. Hooray! Youre rich! Unless the market, instead of doubling, halves, and you are saddled with an obligation to buy 2 million worth of shares which are now worth only 1 million. Youve just borrowed 100,000 and through the power of modern financial instruments used it to lose 1 million. Oops. It might seem unlikely that anyone would do anything that stupid, but in practice it happens all the time. The list of individual traders who have lost more than a billion dollars at a time betting on derivatives is not short: Robert Citron of Orange County, Toshihide Iguchi at Daiwa, Yasuo Hamanaka at Sumitomo and Nick Leeson at Barings, just to take examples from the early 1990s. In Leesons case in 1995, it was a huge unauthorised position in futures on the Nikkei 225, the main Japanese stock exchange. Leeson had been doubling and redoubling his bets in the belief/hope that the index would rise, and hiding the resulting open position a gigantic open-ended bet in a secret account. (Incidentally, Leesons big bet was on the Nikkei holding its level above 18,000. At the time of writing, 12 years later, the index sits at 15,454 proof, if it were needed, that when prices go down they can stay that way for a long time.) The loss eventually amounted to 827 million, and destroyed Barings, Britains oldest merchant bank. The year before it went broke, the chairman of the company, Peter Baring, urbanely told the governor of the Bank of England that it is not actually terribly difficult to make money in the securities business. The power of derivatives is one of the main things about them: their ability to hedge risk, but also, and much more alarmingly, to magnify it. The second main thing about them is their complexity. We have come a long, long way from a single quote for next seasons wheat crop. The contemporary derivative is likely to involve a mix of options and futures and currencies and debt, structured and priced in ways that are the closest real-life thing to rocket science. Maths PhDs are all over the place in this business. Some of the derivatives are actively designed to conceal the real nature of the assets involved bearing in mind that the assets are themselves often debts, repackaged and sold on in black box structures designed to hide the entities within. The products thus created are way over the heads of civilians and sometimes, it seems, over the heads of most of the people who buy and sell them. We invented this stuff, so we know how it works, Tony told me (his bank was one of the first players in the derivatives market). But I get the feeling that a lot of

the banks are doing it just because other people are doing it they dont really know what theyre doing. The complexity is such that even the people who know what theyre doing dont always know what theyre doing. Derivatives are extensively used in arbitrage. Thats the name of investments which effectively bet both ways on the market, exploiting small differences in price to make what should be risk-free profits. (Its what Leeson was supposed to be doing, exploiting tiny differences in the price of Nikkei 225 futures between the Osaka Securities Exchange, where trading was electronic, and the Singapore International Monetary Exchange, where it wasnt. The gap in price would last only for a couple of seconds, and in that gap Barings would buy low and sell high a guaranteed, risk-free profit.) The complexity of the mathematics involved in derivatives cant be exaggerated. This was the reason John Meriwether, a famous bond trader, employed Myron Scholes of the Scholes-Black equation and the man with whom Scholes shared the 1997 Nobel Prize in Economics, Robert Merton, to be directors and co-founders of his new hedge fund Long-Term Capital Management. (A word on the term hedge fund: it is misleading. Hedge funds are pools of private capital, operating without the legal restrictions that affect other forms of collective investment. Many of them make big bets on the markets, using super-sophisticated rocket-sciencey investment techniques.) The idea was to use these big brains to create a highly leveraged, arbitraged, no-risk investment portfolio designed to profit whatever happened, whether the market went up, down, sideways or popped out for a cheese sandwich. LTCM quadrupled in value in its first four years, then imploded in the chaos that followed Russias default on its foreign-debt obligations in 1998. The fund had equity thats to say, actual money you could put your hands on of $4.72 billion, which sounds pretty healthy, except that it was exposed, thanks to the miracles of borrowing, leverage and derivatives, to $1.25 trillion of risk. So if it went broke, LTCM would leave a $1.25 trillion hole in the global financial system. The big brains had made a classic mistake: they treated a very unlikely thing (the default and its consequences) as if it were impossible. As Keynes once observed (he who made himself and his college rich by spending half an hour a day in bed playing the stock market), there is nothing so disastrous as a rational policy in an irrational world. Derivatives, in their modern form, are the most powerful and the most complicated financial instruments ever devised. The third crucial thing about them is that they are everywhere. In 2003 the total size of the world economy was $49,000,000,000,000. The total size of the derivatives being traded was $85,000,000,000,000. In other words, derivatives today are worth far, far more than the total economic activity of the planet. More than $1,000,000,000,000 of derivatives are bought and sold every day. Every single thing that can be traded through derivatives, is. In the words of Warren Buffett, the greatest living stock market investor, The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen). At Enron, for example, newsprint and broadband derivatives, due to be settled many years in the future, were put on the books. Or say you want to write a contract speculating on the number of twins to

be born in Nebraska in 2020. No problem at a price, you will easily find an obliging counterparty. Many companies which look as if their business is to do other things are in reality in the derivatives business Enron being the best-known example. Buffett is a derivative-phobe, not least because he prefers to know whats going on in the companies he invests in, and derivatives make that effectively impossible: No matter how financially sophisticated you are, you cant possibly learn from reading the disclosure documents of a derivatives-intensive company what risks lurk in its positions. Indeed, the more you know about derivatives, the less you will feel you can learn from the disclosures normally proffered you. In Darwins words, Ignorance more frequently begets confidence than does knowledge. The Northern Rock crisis saw all these factors being brought together. The Rock is a bank with roots in the North-East. It had grown to be the fifth biggest mortgage lender in the UK by offering an attractive package of loans, many of them via accounts that are managed over the internet. Its rates are competitive and it used to have a good reputation in its dealings with customers, unlike the four main high street banks which are, as James Buchan once wrote, mere burdens on the earth. Not one saver in ten thousand would have been aware that the reason the Rocks interest rates were so competitive was that it dealt on the global markets to fund itself. Only 27 per cent of its funds were retail, i.e. money deposited by savers: fully 70 per cent of the Rocks funding was wholesale, i.e. came from international markets. So the Rock is lending long-term, in 25-year mortgages, but borrowing short-term to fund itself. That is a well-known recipe for trouble. In addition, the Rock uses offshore trusts to package its mortgages together into asset-based securities bundles of debt that could be sold on to other investment institutions. One thing worth bearing in mind is that in terms of its underlying assets, the Rock seems fine; there is no reason for thinking that its mortgage-payers are failing to cough up. The Rocks problem was that this business model depends on liquidity. Because it gets 70 per cent funding on the wholesale markets, if those markets arent working, it is instantly in deep shit. Over the summer, those markets seized up, and banks became reluctant to lend money to each other and especially reluctant to lend money to anyone with an exposure to high-yield mortgages. Remember the interlocking nature of bank deposits, and how the system relies on liquidity? Over the summer, that liquidity dried up. The Rock had to turn to the Bank of England, the lender of last resort, to borrow the money to stay in business; when news got out, savers wanted their money back, but the banks website crashed, so they began turning up in person to withdraw their deposits, and lo and behold we had a genuine bank run. On 14 September, so many people turned up in person to withdraw money that the bank ended up paying out 5 per cent of its total assets, a cool 1 billion in cash.

The guilty party was the usual baroque financial instrument: in this case, a Collateralised Debt Obligation, or CDO. During boom times, banks lend money more and more freely, and begin to look for growth in places where they hadnt before. In this case, the growth area for American financial institutions was in lending money to poor people whom they wouldnt previously touch. The banks didnt exactly go skipping around trailer parks handing out leaflets offering Buy One Get One Free mortgages except that they did, sort of. The great thing about these poor people was that because their credit history was poor to non-existent they could be charged extravagantly high rates of interest. There was a huge demand for these new mortgages, which in many cases allowed people to own their homes for the first time. By 2005, one in five American mortgages was of this new kind. The mortgages were then bundled together and turned into CDOs. These were packages of debt: some of it beautifully high-yielding, high-interest sub-prime debt. (Prime debt refers to the people youre sure will pay it back; with sub-prime debt, youre less sure, so you charge the borrower more for the privilege of borrowing.) The packages were structured to pay out different rates of interest based on different levels of risk; some of the debt rated AAA, the safest available, and some of it riskier and more lucrative. These were then sold as bonds on the international markets this being a huge growth area in recent years. The market in mortgage-backed bonds currently stands at $6.8 trillion. It is the biggest component of the $27 trillion US bond market, bigger even than US Treasury bonds: $1.3 trillion of that is sub-prime lending. Then trouble struck. The problem was that interest rates in America went up, just as many of the sub-prime borrowers were coming off their first two years of fixed-rate mortgages, so their rates zoomed up, and many of them couldnt afford to pay. The result has been a wave of home repossessions. A BBC report made a study of Cleveland, Ohio, where the banks lent heavily in poor black areas. It found that in Cleveland, one home in ten has now been repossessed, and the biggest landlord in the city is Deutsche Bank Trust. The banking system is facing a multiple whammy. The unpaid mortgages are one thing; the losses on those mortgage-backed bonds are another. And as for the effect on the banks share prices So far, the announced losses amount to $60 billion, and the heads of two of the biggest American banks have lost their jobs, Chuck Prince at Citigroup (loss: $5.9 billion announced with $8-11 billion more to come) and Stan ONeal at Merrill Lynch (loss: $8 billion). But the really big worry concerns a further category of derivatives based on the sub-prime mortgages. Many banks are thought to have huge positions in these, hidden in what are known as structured investment vehicles. These dont appear on the banks books, but their liabilities are real, and if one or other of them blows up la LTCM, it could leave a gigantic hole not just in the individual banks accounts but in the whole global financial system. That was the reason banks suddenly became reluctant to lend money to each other, and liquidity dried up, and Northern Rock almost collapsed. The problem was that the sub-prime derivatives were passed around and sold from bank to bank in an entirely untransparent way, in a gigantic

game of pass-the-parcel. An unfortunate family is unable to meet its mortgage payments in Dumpsville, Arizona; that default is passed through the mortgage lender via the CDO to the international bond market, where it is sold and resold and ends well, thats the whole point: no one knows where it ends. No one knows who is holding the parcel. The complexities are such that even when the parcel is unwrapped and opened, people still dont know the full details of whats in it. Merrill Lynch announced a CDO loss of $5 billion on 5 October and then added another $3 billion on 24 October; the supposedly conservative Swiss bank UBS announced a loss of $3.4 billion in October and then another of $10 billion on 10 December. No one knows who is at risk from the imploding sub-prime mortgages, because no one knows who owns that risk. As a result, the banks became reluctant to lend money to each other, because no one wants to lend money to someone who might not be able to pay it back, and because all banks are trying to make their balance sheets look as plumped-up and cashed-up as possible. Since a credit crunch of this type is by no means unknown it is in fact a pretty regular feature of financial markets we may well wonder why Northern Rock had a business model that couldnt survive one. It seems incredibly stupid. It may be that the Bank of England privately thought so too, and wouldnt have minded allowing the Rock to go under. If the Rocks shareholders had invested in a business with a fundamental flaw and lost all their money as a result, tough shit: they should have read the fine print. But if the Bank wouldnt have minded punishing the Rock, it couldnt take the same attitude to the people who had entrusted it with their savings. Just as the Bank of England had to rescue Johnson Matthey Bank in 1984, because it was one of the five UK banks authorised to trade in gold, it had to rescue the Rock for the sake not of its investors, but of its savers. In this respect, the Bank was asleep at the wheel. The UK system of deposit protection gave a full guarantee only for the first 2000 of savings, and 90 per cent of the next 33,000. Actually extracting that money was famously laborious and would take months of form-filling. After the crisis, when it was too late, the Bank promised to extend its deposit protection to 100,000 and to speed up procedures for repayment. If those measures had been in place in September, the Rock could have been allowed to go broke and the bankers who created this and other similarly over-ingenious structures would have been put on notice. Instead, the Bank of England bailed out the Rock to the tune, so far, of 25 billion. Thats the biggest sum any government anywhere in the world has ever given to a private company. It may turn out the government has no choice but to announce that it has (accidentally and inadvertently) nationalised the Rock. So the story of Northern Rock was a fuck-up. The trouble is that it may turn out to be a harbinger of meltdown too. As Clive Briault of the Financial Services Authority pointed out on 4 December, we in the UK have had 67 consecutive quarters of economic growth. Inflation is low and so is unemployment. (Actually, the unemployment figures are almost laughably rigged but thats another subject. Suffice it to say that pretty much everybody who wants work can find it.) Everything that goes up must come down, and it was inevitable and indeed necessary for things to cool off a bit. The danger is that they might do much more than that. Our economic good times have been funded to a large extent by personal debt, which has in turn been funded by rising house

prices. This has made people feel very confident about their finances, and often led them to treat their homes, via remortgaging, as giant cash machines. But the fright caused by the sub-prime disaster a disaster playing out in slow motion, with more bad news certain to come is going to cause a tightening up of credit. Banks are going to become increasingly cautious about lending money. Theyll lend it to fewer people and charge more money for the privilege. People think that mortgages are priced at a rate linked to the Bank of Englands interest rates, but thats not directly the case: they are priced according to the rate at which banks can borrow money from each other. That rate is under pressure from the sub-prime fiasco. UK personal debt comes to a cool 1,400,000,000,000, and all of it is about to be costlier to pay off. Next year, 1.4 million fixed-rate mortgages are due to come onto the new floating rates, which will be much more expensive. Its the same thing that triggered the wave of repossessions across the US. Add to that the fact that the British market now has 108 billion worth of buy-to-let mortgages, which are particularly exposed to a dip in house prices combined with a rise in interest rates, and you would be forgiven for thinking that some sort of crash is imminent. The central banks obviously think the risk is very real, because on 12 December, the US, EU, UK, Canadian and Swiss central banks announced that they were joining together to provide 50 billion worth of liquidity to the financial markets. Because banks are reluctant to lend to each other, the central banks will make the funds available instead. This might help, or it might be a sign of anxiety so big that it accidentally makes things worse but it was worth a shot. My friend Tony, however, is sanguine. Sorting out whos in the shit is going to be a nightmare, but when it all shakes out, all itll mean is that credit is a little bit more expensive. Thats a good thing. It had got crazy. It was cheaper for companies to borrow money from other companies than it was for governments. Thats nuts. These things are cyclical, it had all just gone too far and we needed a correction. So well have to stop running around spending money like drunken sailors, I said. Well, drunk sailors tend to be spending their own money, Tony said. By contemporary standards theyre quite prudent. This is a good moment for a reappraisal of the Citys relationship with the rest of Britain. We are about to have a slowdown, or a recession, or a meltdown, that is in some part triggered by high-risk activities on the part of financial institutions. It comes down to a question of risk, which in turn is a question of just who is bearing the risks and this, it seems to me, is where the current financial system is badly out of kilter. Before John Meriwether became the mastermind behind Long-Term Capital Management, he was one of the star characters in Michael Lewiss highly entertaining Liars Poker, an account of the excesses of Wall Street bond traders in the 1980s. Meriwether is the lead character in the books famous first scene, in which John Gutfreund, the chairman of Salomon Brothers, challenges him, then the chief bond trader, to a game of Liars Poker: One hand, one million dollars, no tears.

(Liars Poker is a game of bluffing in which you bet on the serial number of dollar bills.) That wasnt a colossal sum to Gutfreund, though it was to Meriwether which made what he did next all the more audacious. No, John, he told his boss, if were going to play for those kind of numbers, Id rather play for real money. Ten million dollars. No tears. That amount would have bankrupted Meriwether, but it would have put a horrible crimp even in Gutfreunds style; hed have had to sell things to raise it, and explain to his wife why they wouldnt be having a holiday this year, and all that. So the chairman of Salomon slunk away with his tail between his legs and Meriwethers reputation was permanently established as to use the elegant period phrase a big swinging dick. Societies dont have to love people like Meriwether, just as we dont have to love the kind of people who become soldiers or surgeons, but we do need them gamblers, risk-takers. The longest and best established principle of investment is that rewards are linked to risks: you cant earn more than other people without risking more than they do. The early capitalists who funded sea voyages, for instance, did so on the clear understanding that if the ship came back, they would be rich, and if it didnt come back, they would be broke. Playing Liars Poker, Meriwether was risking his own money. The trouble with derivatives, however, is that they magnify the risk and spread it through the financial system to such an extent that now, when men like Meriwether, or indeed like the management of Northern Rock, make their colossal bets, we bear the risk as well, unwillingly and unwittingly. A trillion-dollar market catastrophe would have consequences for everybody. In the words of Warren Buffett, The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Knowledge of how dangerous they are has already permeated the electricity and gas businesses, in which the eruption of major troubles caused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives business continues to expand unchecked. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts. He said that five years ago, and there is no sign that effective action has been taken or even seriously contemplated. Banks are exercising greater notional care over their exposure to risk its not as if anyone actively wants to lose money. But the yearning for increased rewards is as strong as it ever was, and higher rewards mean higher risks. Most City commentators would tell us that this is yet another area in which the cure for a problem caused by the markets is more reliance on market forces. That faith seems to me to verge on the mystical.

Bank legislation tends to be reactive. When the market blows up, laws are passed to try and prevent a repetition of whatever it was that just happened. The most recent example was the Sarbanes-Oxley Act in the US, designed to control corporate accounting practices and passed in the aftermath of the Enron and other dgringolades. If there is a derivative-induced meltdown over the next months, similar laws will be passed. Im not going to pretend to know what theyll be, but an obvious target would be the off-the-balance-sheet structures which at the moment allow banks to hide huge risks from public disclosure. One of the few victories of the collective polity over the financial industries though its not one much celebrated in the financial press came in 1991. The House of Lords ruled that Hammersmith and Fulham didnt have to pay the huge sums it had lost investing in swaps (a kind of derivative) because its participation in the activity had been illegal to start with. That ruling affected 130 councils which had done similar deals, almost always to get around Tory rate-capping, and cost the 75 banks involved an estimated 750 million. The City hated that but the principle established was an important one: these deals are not beyond the law. If our laws are not extended to control the new kinds of super-powerful, super-complex and potentially super-risky investment vehicles, they will one day cause a financial disaster of globalsystemic proportions. Still, lets look on the bright side: at least City bonuses will be smaller this year.

October 2008

Cityphobia

Byron wrote that I think it great affectation not to quote oneself. On that basis, Id like to quote what I wrote in a piece about the City of London, in the aftermath of the Northern Rock fiasco: If our laws are not extended to control the new kinds of super-powerful, super-complex and potentially super-risky investment vehicles, they will one day cause a financial disaster of globalsystemic proportions.[*] The prediction was right, but the tense was wrong. The disaster had already happened, it just hadnt yet played itself out in the markets. It is doing so now, though. The recipe is starting to become well known, but perhaps its worth spelling it out one more time. Financial institutions in the US lent money to people with poor credit histories. This wasnt a bad thing in itself, indeed it could be seen as an example of capitalism at its most beneficently creative indigent housebuyers needing loans, financial institutions wanting high-interest-paying borrowers, and presto! a new class of homeowners coming into being. Unfortunately, a lot of the lending was reckless, verging on criminal; for a glimpse at how chaotic and wild-westish the process became, take a look at a book by a former Texas mortgage broker, Richard Bitner, called Confessions of a Sub-Prime Lender.[] The invention which made it possible for the lending to become so reckless was securitisation: the process by which loans were added together and sold on to other institutions as packages of debt. This had the effect of making the initial lender indifferent to whether or not the loan could be repaid hed already sold the debt to someone else, so he didnt need to care. These packages of debt were then sold on and resold in the form of horrendously complex and sophisticated financial instruments, and it is these which are the basis of the global jamming-up of capital markets. The interlinked and overlapping loans are so complicated that no one knows who owns what underlying debt, and furthermore, no one knows what these assets are worth. (If you own someone elses debt, it counts as an asset.) The normal mechanism for assessing the value of these assets is the market: they are worth what someone is prepared to pay. At the moment, because no one is buying, no one has a clue what theyre worth, if anything. Because of an accountancy practice called mark to market, requiring that assets be listed at their current values, this fact had to be reflected in the companies balance sheets so these balance sheets suddenly looked disastrous. As a result, banks are reluctant to lend to each other, and the entire financial system has ground to a halt: such capital as is moving in the markets is supplied by the central banks, which have to date pumped in hundreds of billions of dollars to generate some liquidity. The scorecard so far is impressive, and it began with Northern Rock, done in by Britains first bank run in 150 years. The bank was a demutualised former mutual society. It had adopted a groovy, gogo financial strategy: only 27 per cent of its funds came from money deposited in its accounts by savers; the rest came from short-term borrowing, on an as-and-when-needed basis, from the international money markets. When those markets choked up the Rock sought emergency funding from the Bank of England, which acted too slowly and by doing so triggered the run on the Rock,

which led, after a certain amount of governmental faffing about, to its nationalisation on 17 February. Note that the Rock wasnt destroyed by risky lending. Some of its loans were risky: a banker contact of mine told me that there was trouble with a book of mortgage loans for 120 per cent of the value of homes. (Why would any sane person want to borrow 120 per cent of the value of the thing they wanted to buy? I can just about answer that question: because they want to do the place up, or spend the extra on a new car, and because all parties involved are mortally certain that the price is going to go up. But its still crazily reckless. Why would any sane lender lend the money? No idea.) But while loans like this did nothing to help the Rock, what ruined the bank was its exposure to the now malfunctioning money markets. Next to go was the US investment bank Bear Stearns. This bank, super-bullish even by the standards of Wall Street, had too great an exposure to sub-prime debt; investors fled, the share price collapsed, and on 16 March the bank was bought by its competitor J.P. Morgan, its market value having declined from $20 billion to $236 million. The US government underwrote the purchase by providing a guarantee of $29 billion against the banks mortgage liabilities basically, the government took on the risk of the dodgy mortgages, in order to make the rest of the bank viable for purchase. They did so because they were worried about the risk to the rest of the banking system if Bear Stearns collapsed and a chaotic unwinding of the financial system followed. Chaotic unwinding good phrase. It was coined by Ben Bernanke, chairman of the US Federal Reserve, and formerly an academic whose special subject of study, usefully, was the Great Depression. Fannie Mae and Freddie Mac, on the other hand, were more directly done in by bad loans. These odd institutions are/were a hybrid, with capital drawn from shareholders but underwriting from the US government: their function was not to lend money to the public directly but to underwrite the mortgages given by other institutions, and to provide liquidity to the mortgage markets. They are Government Sponsored Enterprises whose deposits are not guaranteed by the government, a fact stated in the law founding them, on the securities themselves, and basically on every press release or document ever emanating from either GSE and a fact nobody believed, since it was generally felt certain that if Fannie and Freddie ever got into trouble, the government would have no choice but to bail them out. That assumption turned out to be correct. After the collapse in US house prices and the soaring default rate of mortgages, Freddie and Fannie, with mortgage-backed securities worth, or maybe that should be worth, $5 trillion and debt of $1.6 trillion, were on the verge of going under, and they were taken into conservatorship by the US government on 7 September. The term conservatorship fails to mask the fact that this was, by cash value, the biggest nationalisation in the history of the world. It was followed eight days later by the largest bankruptcy in the history of the world, when the investment bank Lehman Brothers went into Chapter 11, the American form of receivership. (Chapter 11 is a much more business-friendly form

of bankruptcy than pertains in other countries, and has been compared to leaving the fox in charge of the henhouse.) Lehman had an impressive $613 billion of debt, but some parts of its various businesses were viable: it was the holding company that went broke, leaving the subsidiary businesses free to be sold off. The main one, the US investment banking arm, was bought by Barclays for $250 million, with another $1.5 billion for buildings and data centres. Oh, and an important part of the deal was the $2.5 billion in bonuses that would be paid for the banks New York staff. The previous year, Lehmans bonuses were $5.7 billion. If you are wondering how a total of $8,200,000,000 could be paid in bonuses over two years to the great minds whose company went bankrupt, well, what can I tell you? The bonus question is often seen as a tragicomic footnote to the business of banking, but it may be that it goes close to the heart of the problem of how we got to be in this place. Through history, the great fortunes have been made by people directly taking risks on their own account. Today, great fortunes are made by employees, doing nothing other than their jobs: jobs which, in the case of bankers, involve taking on risks, usually with other peoples borrowed money. To make more money, and earn more bonuses (which are usually 60 per cent of an investment bankers pay), its simple: you just take on more risk. The upside is the upside, and the downside well, it increasingly seems that for the bankers themselves, certainly in the case of Lehman New York, there isnt one. This undermines the whole principle of moral hazard, which was the idea behind letting Lehman go under in the first place the need for companies to face the consequences of their decisions. This principle obviously collapses if the individuals involved dont face any consequences. There had been talk about the big banks being too big to fail, meaning that the risk of allowing them to go under was too great, but by allowing Lehman to go under the US Treasury seemed to be making the point that where possible it would allow the market to take its course. The markets reacted to this with horror. It is now received wisdom in the markets that it was the US governments willingness to let Lehman Brothers fail which triggered the meltdown, by causing fear to become panic. The day after the biggest bankruptcy in history saw the biggest bail-out of a private company in history, with the US government taking a 79.9 per cent share in the insurer AIG in return for a loan facility of $85 billion. AIG was exposed to a lot of bad loans, and it had emerged that it was valuing its mortgage securities at 1.7 to two times as much as Lehman had valued theirs. So if Lehman was broke, AIG was in an even worse position. The share price had collapsed by 95 per cent when the Federal Reserve was brought in to stage its rescue. The suddenness of these implosions, and their spectacular scale, masked what would otherwise have been a gigantic story: Merrill Lynch, the bank whose symbol is the original Wall Street prancing bull, was taken over by the Bank of America on 14 September, after a year of huge losses linked to sub-prime mortgages and their derivatives. On 21 September, Goldman Sachs, the worlds biggest investment bank, and Morgan Stanley converted their legal status from investment banks to holding banks, a change which allowed them access to help from the Federal Reserve in return for a greatly increased level of government supervision. Goldman had done all right in the initial phases of the credit crunch, because although it was exposed to mortgage-backed securities,

it also made big bets that the securities would fall, thus offsetting its own losses. But the general turn against banking stocks nonetheless did for its status as an investment bank. That means that in the last months the five biggest investment banks in New York Bear Stearns, Merrill Lynch, Lehman Brothers, Goldman Sachs and Morgan Stanley have ceased to exist as investment banks. On 25 September came the largest bank failure in American history, as Washington Mutual went into receivership following a bank run during which its customers withdrew $16.7 billion in ten days. Taking all these superlatives together, its easy to see why the Federal Reserve and the US Treasury (run by Hank Paulson, former head of Goldman Sachs) decided to step in with their proposal to bail out the US banking system. The idea is to buy up the toxic assets which are poisoning the banking system, so that the banks can go back to lending money to each other again and the system can reboot itself. They must have known that the initial plan wouldnt pass unamended: it was only three pages long and the only power it didnt grant Paulson was the right to call himself God-King Hank the First. After being knocked back by the House of Representatives, it hit the floor of the Senate at 451 pages, passed, and then was passed in its amended form by the House. It is a strange document, the bill, crammed with tax cuts and pork and populist gestures but at its heart allowing Paulson to buy any troubled assets he likes at any price he sees fit. Its going to be interesting to put it very, very mildly to see if the bail-out works. The usual model for a crisis of this scale is for the state to take over the troubled institutions, then go through the books separating the good from the bad assets, and selling them off, part one and then part two. This is what was done in the 1980s, when the post-deregulation collapse of the US Savings and Loans (roughly like our old building societies) led to the creation of the Resolution Trust Corporation to sort out and flog off its assets and as optimists are never slow to point out, the Resolution Trust ended by making a profit. The bail-out is an attempt to do part two of that without doing part one, no doubt because the scale of the problem is so big that part one would involve the nationalisation of the entire US banking system. The socialisation of US banking would be a hell of a punchline to decades of unfettered liberal capitalism. As it stands, the plan is socialism for the rich in as pure a form as has ever been seen. The British and European scorecard seemed, at the start, less spectacular. On 18 September, news of the biggest bank merger carefully not denominated a takeover in British history: Lloyds was to buy HBOS, the largest mortgage lender in the UK, with 20 per cent of the market. That market share was precisely the problem: HBOS had expanded in recent years and taken on a disproportionate share of the newer, riskier mortgages, and also was only 58 per cent funded by depositors, the rest of its funds coming from the wholesale markets. That is a much, much safer ratio than the 27 per cent of depositor funding held by Northern Rock, but it was still enough for the share price to collapse and induce a takeover. The price offered by Lloyds was 2.32 a share this for a company which last October was trading for more than 10. On 28 September, the Luxembourg, Belgian and Dutch governments nationalised the bank Fortis, the biggest private employer in Belgium, at a cost of 11.2 billion, after its share price collapsed. On 29 September,

Bradford and Bingley (another demutualised former building society), which had the largest share of the buy-to-let market, was nationalised, at a cost of 41.3 billion, and its branch network sold off to the Spanish bank Santander the classic part one, part two model mentioned above. On 30 September, the Icelandic government nationalised the countrys third largest bank, Giltnir, at a refreshingly modest cost of 500 million. Icelands second biggest bank, Landsbanki, followed on 7 October and its biggest, Kaupthing, on 9 October. The Icelandic government would not guarantee overseas depositors money, including nearly 1 billion of UK local government cash. This caused the British to use anti-terrorism legislation to freeze Landsbankis assets in the UK. The German commercial property loan giant Hypo Real Estate was bailed out on 5 October at a cost of 50 billion. At the same time the German government blurted out that it was guaranteeing the deposits of all savers, a bizarre thing to do given that the previous day it had criticised the Irish government for doing the exact same thing. The German promise caused mayhem all round Europe. It became obvious that the absence of a European equivalent of the Fed able to knock heads together and impose a consistent Eurozone policy is a huge strategic problem for the EU. The markets, which were already troubled, now went into freefall especially banking shares. On 7 October, HBOS and Lloyds both lost 40 per cent of their value. A total collapse seemed possible. In the early hours of 8 October, the British government announced that it was forcing the eight biggest banks to increase their levels of capitalisation, and offering to provide them the money to do that, in return for preference shares. These are a last-in, first-out type of shareholding, without voting rights or a link to the share price. First, though, the object of the exercise is to prevent further systemic meltdown, and to that end the government offered to provide another 200 billion of short-term loans: the kind of loan which the banks would once unthinkingly have made to each other, the kind of loan whose absence is at the heart of the whole current freeze-up. The government is also offering 250 billion of loan guarantees to back loans between the banks. It is a partial form of nationalisation, and constitutes the biggest move to shore up the UK banking system that there has ever been. At the same time, six central banks in the US, UK, EU, Sweden, Switzerland and Canada cut interest rates by 0.5 per cent, and China by 0.27 per cent. Will it work? Lets hope so. No other government has, at the time of writing, moved as systematically or boldly as the British, in simultaneously addressing capitalisation (how much money the banks have), liquidity (their ability and willingness to lend to each other) and interest rates (to help the economy in general). Quite a lot of detail is missing: the assurances about bankers pay and suchlike are woolly. The Treasury and the government clearly hope that these huge new moves will bring the market to its senses, and allow us to have a good old-fashioned recession, rather than a full-scale depression. One of the structural problems which brought us to this pass is that our big banks arent just big, theyre huge: the four biggest each have a capital value of more than a trillion pounds. Add the five biggest together, and the sum is four times the value of Britains GDP. Our (remaining) banks have less exposure to the famous toxic debt than their US counterparts, but while the wholesale money markets arent functioning, normal banking life is impossible. They are highly leveraged, too. It

was this combination of size and leverage that did for Icelands banks. The ratio of Barclays assets to its equity in June hit 61.3 to 1. Imagine that for a moment translated to your own finances, so that you could stretch what you actually, unequivocally own to borrow more than sixty times the amount. (Id have an island. What about you?) It sounds sensible to reduce that leverage, and indeed it is, except that the process of reducing it is the dreaded deleveraging which is causing the banking system and the wider economy to grind to a halt. The scale of bank leveraging is one of the things that must be targeted by regulators if/when the crisis has passed; we cant let the banks get this far out of control ever again. For a start, there must be a tight limit on the relationship between banks debt and their equity, and much greater transparency about the nature of banks assets. So: a huge unregulated boom in which almost all the upside went directly into private hands, followed by a gigantic bust in which the losses were socialised. That is literally nobodys idea of how the financial system is supposed to work. It is just as much an abomination to the free marketeer as it is to the social democrat or outright leftist. But the models and alternatives dont seem to be forthcoming: there is an ideological and theoretical vacuum where the challenge from the left used to be. Capitalism no longer has a global antagonist, just at the moment when it has never needed one more if only to clarify thinking and values, and to provide the chorus of jeering and Schadenfreude which at this moment is deeply appropriate. I would be providing it myself if I werent so frightened. Having fully indulged their greed on the way up, and created the risks, the bankers are now fully indulging their fear on the way down, and allowing the system to seize up. But it wasnt just the banks. One thing which has been lacking in public discourse about the crisis is someone to point out that we did this to ourselves, because we allowed our governments to do it, and because we were greedy and stupid. Its not just bankers who have been indulging in greed, short-termism and fantasy economics. In addition to our stretched mortgage borrowing, Britain has half of the total European credit-card debt. That is a horrible fact, and although its nice to reserve the blame for banks who made lending too easy, the great British public is just as much to blame. We grew obsessed with the price of our houses, felt richer than we should, borrowed money we didnt have, spent it on tat, and now that the downturn has happened as it was bound to do we want someone else to blame. Well boo fucking hoo. Bankers are to blame, but were to blame too. Thats just as well, because were the ones who are going to have to pay. Other than that, its too early to draw general conclusions from this amazing crisis. What will, what must, die is the mystical belief in the power of the markets that has dominated political and economic discourse in most of the Western world for the last several decades. The markets have so manifestly, so flagrantly malfunctioned that we cant go back to the idea of unfettered liberal capitalism as a talisman, template or magic wand. The unquestioned Cityphilia I wrote about earlier this year is gone, I hope for ever. Unfortunately, we have no current model of where to go from here, apart from a more heavily regulated form of growth-based liberal capitalism. There will be more intrusive regulation, more proactive interference. There may even be (there should be) a new Bretton Woods to control the global flow of capital. That doesnt seem enough, but in the

absence of another set of ideas about how the world should work, it may turn out to be what we have to settle for. In the meantime, its seatbelt sign on, sickbag to hand, and that deep, bitter, prayerful longing for smooth air.